November 2010 Wal-Mart Price: $55 Research Report by Peter Hughes, Check Capital Management

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1 November 2010 Wal-Mart Price: $55 Research Report by Peter Hughes, Check Capital Management Wal-Mart (WMT) is by far the world s largest retailer. The company has over 8700 stores, with 49% of those outside the United States. WMT has famously low prices, which it achieves through expert merchandising and economies of scale. In evaluating Wal-Mart, consider that: The company has increased its sales, dividends and earningsper-share (EPS) every year for at least 35 years. It employs two million people worldwide and is the largest private employer in the U.S. WMT s sales in 2010 will approach $420B. This exceeds the GDP of all but 21 countries in the world and is larger than the sales of the world s next four largest retailers combined. [Note: All dates in this report correspond with the calendar year, not Wal-Mart s fiscal year, which ends in January.] THE BUSINESS WMT s formula for success is simple: offer lower prices than competitors. This is how Wal- Mart remains the destination of choice for many price-conscious consumers. [68% of U.S. sales come from families with household incomes below $70,000.] Because prices are consistently $450 $400 $350 $300 $250 $200 $150 $100 $50 $- $4.50 $4.00 $3.50 $3.00 $2.50 $2.00 $1.50 $1.00 $0.50 $0.00 Earnings and Dividends Per Share * EPS Dividend/Share * Expected Results in 2010 World's Largest Retailers (2009 Sales in Billions) Wal-Mart Carrefour Tesco Metro AG Kroger Costco Home Depot low, WMT has few sales events and thus saves on advertising costs. As the company rolls out new stores and tweaks its offerings, sales and earnings continue to climb. Wal-Mart has grown remarkably since its first store opened in Earnings-per-share have grown at an average annual rate of 13% over the last 15 years and nearly 11% for the last five years. The company achieved such growth by finding ways to reinvest its cashflow and earn solid returns on capital. The key to attaining these returns is WMT s low cost structure. The firm is able to offer the lowest prices due to its operational efficiency and economies of scale. Target 1 Check Capital Management Inc. Costa Mesa, CA. (714) (800)

2 Operational Efficiency Wal-Mart pioneered the use of supply-chain inventory management. Retailers results typically suffer because of inventory miscues items are unavailable when needed or languish on store shelves, tying up capital and eventually being sold at significant markdowns. WMT does an exceptional job of managing its inventory supply chain by using a management system called Retail Link, which provides suppliers with sales-trend information, enabling them to respond quickly and improve efficiency. Managers are able to make real-time decisions about which merchandise is in demand and needs to be reordered. Thus, merchandise arrives on the shelves just when needed, increasing inventory turnover. Even though the company has a very small margin on each item it sells, its rapid turnover means that annual profit per foot of shelf space is extremely high. According to some reports, WMT sells over 60% of its products before even paying for them, making inventory costs for those items essentially zero. To further increase efficiency and drive down costs, Wal-Mart has recently proposed taking over the supply-chain management of some of its largest suppliers. The company is also endeavoring to source more of its inventory directly from producers and manufacturers, reducing middle-man markups. Part of Wal-Mart s logistical success stems from its distribution infrastructure. The company has an impressive system of distribution centers operating 24 hours a day. WMT s strategy is to build new stores within one day s drive from a distribution center. (Usually stores fit in this range.) When there are enough new stores in an area, the firm can open a new distribution center, reducing driving miles and the need to stock inventory in-store. Most competitors outsource their trucking, but Wal-Mart maintains its own fleet of trucks, further lowering costs. Store managers are trained to maximize profits on every square foot of space. Each store is evaluated as a profit center and its performance can be calculated on a real-time basis, making it easy for managers to remain fully informed. Furthermore, each department is monitored so trends can be spotted and adjustments made quickly. Departments are also incentivized to be creative; successful ideas are spread to other stores. Economies of Scale Wal-Mart s size enables it to achieve significant economies of scale relative to rivals. The firm can distribute administrative expenses over a larger number of products sold. Its high store density in many areas contributes to reduced distribution costs. Most important, WMT s size gives it enormous clout with vendors. For numerous manufacturers, getting products into Wal-Mart stores is a make-or-break issue, so WMT is able to negotiate very low prices. 30% 25% 20% 15% 10% 5% 0% Clorox Percent of Sales to Wal-Mart General Mills Kraft Procter & Gamble Kimberly- Clark 2 Check Capital Management Inc. Costa Mesa, CA. (714) (800)

3 Even for some of the world s biggest producers, sales to Wal-Mart makes up a large percentage of total revenues, allowing WMT to get quantity discounts (see chart on page 2). The firm constantly works with vendors to lower prices and then passes those savings on to customers. Competition Wal-Mart is being pressured by competitors. It is being undercut by firms like Costco and the various Dollar stores. Costco sells far fewer items and its bulk-quantity strategy allows it to sell for prices which are very competitive with Wal-Mart. Similarly, firms like Family Dollar, Dollar General and Dollar Tree have carved out market niches that appeal to the price-conscious crowd. At the other end of the spectrum, Target has successfully positioned itself as the upscale discounter. Its stores are often newer and better maintained than Wal-Mart s and its Expect More, Pay Less motto appeals to consumers who are not solely focused on price. These tough competitors continue to crimp Wal-Mart s growth. Recent Performance Despite its strengths, Wal-Mart s growth is slowing. Sales grew 3.8% in the first three quarters of 2010, although EPS rose 13% as margins widened. Management expects EPS of $4.08-$4.12 for all of WMT outperformed its peers during the recession, as consumers focused more on value. An improving economy may return some of those shoppers to higher-priced rivals. FUTURE GROWTH Wal-Mart is the victim of its own success. The firm increased its super-center count from 441 in 1997 to 2880 in The firm s marketshare went up, but new stores now often cannibalize older stores sales. WMT s U.S. business is now mature, and its advanced market penetration makes future growth increasingly difficult. As the graph below shows, the firm s same-store sales have been slipping for a decade and have posted a slight decline thus far in Wal-Mart s success will now depend on its ability to earn reasonable rates of return on reinvested profits. In 2008, investors began pressuring WMT to reduce its 6% domestic store expansion, which was Annual Change in U.S. Same-Store Sales viewed as an increasingly low-return 5% investment. Management acquiesced, and this was an important, positive step 4% for the company. In 2006, Wal-Mart 3% increased its U.S. selling space by 42 2% million feet. In 2010 the increase will be only 11 million. The company is 1% now spending $2B-$3B less on capital 0% expenditures and focuses more on remodeling -1% current stores than building -2% new ones. The saved money is being reallocated to foreign expansion and * returned to shareholders. * Year to date (through 10/31/2010) 3 Check Capital Management Inc. Costa Mesa, CA. (714) (800)

4 Because Wal-Mart s ability to open new stores in the United States is limited, it is pursuing other growth strategies, including tinkering with its domestic formula and international expansion. The company has proven savvy at finding ways to incrementally improve results in the U.S. and will likely be able to continue adjusting its U.S. offering to marginally increase returns. The firm has recently announced two new strategies to stimulate growth in urban areas. One is a partnership with FedEx, which will allow consumers to buy merchandise online and then pick it up, with no shipping cost, at any FedEx outlet. WMT is also beginning to open new stores in urban areas that heretofore could not support a Wal-Mart. The new stores will utilize much smaller formats (20,000-60,000 square feet, versus 185,000 for a typical supercenter) and focus mostly on groceries. Some of WMT s past moves have greatly increased profitability over time: 1978 Opening pharmacies and automotive service centers in stores Opened the first Sam s Club to compete in the wholesale-club category. There are now 608 Sam s Club stores Began using the Supercenter format. These larger stores offer photo processing, optical products/exams, fast food and groceries Opened the first of many Neighborhood Market grocery stores. Groceries now account for 51% of International Sales as Percent of Total Revenues WMT s U.S. sales. The 30% company is now the largest grocer in the U.S., with a 20% share of the market. 25% 2006 Began to offer onemonth supplies of many 20% generic drugs for $4, resulting in additional foot traffic from consumers 15% who might not otherwise * visit Wal-Mart. * Year to date (through 10/31/2010) Wal-Mart s bigger opportunity, however, lies overseas. Given its retailing expertise, WMT is likely to be successful in many international markets. In 2010, foreign operations accounted for 26% of sales. The firm operates stores in 14 foreign countries, under 46 different banners, with multiple sizes and formats. WMT s greatest foreign success has come in developing countries, particularly Mexico and the rest of Latin America. In these markets, consumers are drawn to the firm s low prices. Wal-Mart has over 1400 stores in Mexico, plus 1200 in Central and South America. The firm has experienced less success in first- Mexico 36% Stores Outside the U.S. UK 9% Japan 9% South America 18% Central America 12% Canada 8% China 7% Other 1% 4 Check Capital Management Inc. Costa Mesa, CA. (714) (800)

5 world nations, where it faces more entrenched competition. It exited the German and South Korean markets in 2006 and has since focused on emerging-market opportunities. The company has utilized acquisitions to enter some foreign markets. In 2006, Wal-Mart acquired a 35% stake in Taiwanese retailer Trust-Mart to help WMT s operation in mainland China. It has made similar acquisitions in Brazil, India and Chile over the past five years. The company is currently in talks to buy South Africa s Massmart for $4 billion. Wal-Mart added 532 new overseas stores in 2009 and now has over 4200 outside the U.S. The company is gaining share in almost all of these markets. FINANCIAL METRICS As the graph at right shows, Wal- Mart s key financial metrics have remained very consistent over the past decade. Its efficient operating system enables it to earn an enviable return-on-capital (14%) despite its low net margin. Key Statistics (trailing four quarters ending 10/31/2010) Revenue Net Income Debt EPS Net Margin ROC $416B $14.9B $40.8B $ % 14.1% 16.0% 14.0% Operating Metrics Management s most important decision will be how to allocate the company s enormous cashflow. Choosing to reduce capital expenditures and spend more on share repurchases and dividends is a conservative choice. Since 2000, Wal-Mart s share count has declined 18%. Meanwhile, the firm s debt load remains reasonable at 35% of total capitalization. 12.0% 10.0% 8.0% 6.0% 4.0% 2.0% 0.0% Return on Capital Net Margin The bar chart on the next page shows that WMT has returned a large portion of its cashflow to shareholders. Since 2006, Wal-Mart has distributed 77% of its earnings to shareholders in the form of dividends and share repurchases. Thus far in 2010 the company has earned $9.6B and returned $14.3B to shareholders through dividends ($3.3B) and share buybacks ($11.0B). It has been able to do this due to strong cashflow and improved capital management. VALUATION Wal-Mart s competitive advantages are strong and its business is recession-resistant. However, its growth opportunities remain uncertain. The firm needs to prove that it can maintain its excellence, now that most of its growth will come from foreign markets. The management team is very experienced and stable, increasing the likelihood that its operational success will continue. 5 Check Capital Management Inc. Costa Mesa, CA. (714) (800)

6 Wal-Mart stock hit a high of $70 (with a P/E ratio of 55) in Since then, the company s EPS has increased 216% while the stock has declined 21%. Shares now trade for under 14 times earnings and pay a 2.2% dividend. As the graphs below indicate, WMT is very near the bottom of its long-term valuation. The risk/return tradeoff appears attractive in light of Wal-Mart s consistent success and its stock s historically low valuation. Given the company s strengths, management s focus on shareholder value and a seemingly underpriced stock, owners should be rewarded over time. $20 $18 $16 $14 $12 $10 $8 $6 $4 $2 $0 $70 $60 $50 $40 $30 $20 $10 Money Returned to Shareholders (in $ billions) * Buybacks + Dividends Net Income * Expected Results in 2010 Price 15 times Earnings Per Share $ P/E Ratio CCM Research Reports are for informational purposes only and are not an offer to sell or a solicitation to buy. They are not personal recommendations for any particular investor and do not take into account the financial circumstances of any individual investor. Check Capital, or one of its officers, may have a position in the securities discussed and may purchase or sell such securities from time to time. CCM Research Reports are created using third-party data. While Check Capital believes such third-party information is reliable, we do not guarantee its accuracy, timeliness or completeness. 6 Check Capital Management Inc. Costa Mesa, CA. (714) (800)